For most situations, we can assume interest and dividends are small enough to ignore. We will simplify our equation by excluding them. There are situations where interest and dividends do affect this equation such as high interest rates, long time periods or large dividends for example.

Simplifying our equation, we now have

K + C = U + P

Since the strike price is arbitrary and a constant, let’s remove it from the equation to see what the relationship is between the Call, Put and Underlying security price boils down to:

C = U + P

Long is positive and short is negative. So we have

+C = Long Call

-C = Short Call

+P = Long Put

-P = Short Put

+U = Long Stock

-U = Short Stock

This simple equation let’s you derive the six synthetic relationships quite quickly.

Think back to your algebra class and solve what synthetic you need by putting that variable alone on one side and moving the rest to the other side of the equation. Change the sign when moving from one side to the other of the equation (“jumping the fence as my 8th grade teach used to say”).

We can now show the six basic relationships, solved using basic algebra. They are:

Long Call = Long Stock + Long Put (C = U + P)

Short Call = Short Stock + Short Put (-C = -U – P)

Long Put = Long Call + Short Stock (P = C – U)

Short Put = Short Call + Long Stock (-P = -C + U)

Long Stock = Long Call + Short Put (U = C – P)

Short Stock = Short Call + Long Put (-U = -C + P)

How can we use this knowledge?

Hedge an existing position.

Suppose you have a covered write on a stock but earnings are coming out and you’re worried the stock price might jump around a lot. Or you are going on vacation and don’t want to worry what the market is doing while you’re gone.

Since you know a covered write is identical to a short put synthetically, if you buy a long put, that should completely offset your covered write and completely hedge you while you go through earnings. No need to sell your stock and buy in your short call. Just buy a put. Here’s how that would look:

Long stock + Short Call vs Long Put vs Combination

Notice how the blue line is completely flat. That’s the combined position of the long stock, short call and long put.

Reverse Market Directional Bias quickly

Suppose you are bullish on the market and have a Long Call. You change your mind and decide you should be bearish. If you sold your long call and bought long puts, you would have two commissions and two sets of slippage to deal with. Since we know a Long Put = Long Call + Short Stock, all we have to do is SHORT THE STOCK. This changes your position to a synthetic Long Put with one transaction.

This technique is also VERY useful in very fast market conditions. Option bid/ask spreads can really widen during fast markets so your fills closing your Long Call and buying your Long Put might really put you in a hole starting out. Since stocks are very liquid and have very tight bid/ask spreads normally, shorting the stock is a very useful tool to convert your Long Call position during a fast market.

Closing a position with illiquid options using a boxThis happened to me trading 30 Year Treasury Bond futures options (ZB contract) a few years ago. The bid/ask spread of the in-the-money options was really crazy. (Bid $4, Ask $6 for example). I had a profit in a position that had started out as a butterfly. I could close most of the position with good fills; however, I had some ITM options with very unfavorable bid/ask spreads. What did I do? I built a box!

I had these options I needed to close:

A long Put at 118 Strike

A long Call at the 113 strike

To create a riskless position, I did the opposite:

Short Call at the 118 Strike

Short Put at the 113 Strike

I ended up with:

A long Put + Short Call at the 118 strike = a synthetic Short Stock position

A Long Call + Short Put at the 113 strike = a synthetic Long Stock position

Which means I was synthetically Long AND Short the stock (which means there’s no risk left)

I hope you’ve seen how useful synthetic option positions can be. There’s more variations but as long as you understand the basic formula of

Long Call = Long Stock + Long Put

You can re-arrange the equation like in algebra class to put the one variable you need by itself and everything else on the other side of the equation to see what the synthetic is.

We just had a customer chargeback seven months of Ali Pashaei's training. It's difficult to challenge these things without proof that they consumed the materials.

Going forward I will implement better tracking to defend against this non-sense.

In the mean time, we are publishing a page with Chargeback Offenders so other businesses can be alerted to this person's behavior and not do business with them. We hope to slow down fraudulent transactions.

Today you will learn about the risk reversal. It can be used to protect or hedge your stock, position, or portfolio. A risk reversal can be useful to guard against a major market move. Risk reversals can also be used as a directional position.

A risk reversal can be structured so you do not have to take on a lot of risk.

A risk reversal is a position that makes use of a call and a put option, or a call spread option and a put spread option. This can change or flip the risk of the position from bullish to bearish or vice versa. The risk reversal is sometimes referred to as a combo.

Risk reversals are very flexible, and can be a good tool to use for your trading.

How the Risk Reversal got its’ Name…

Legend has it that large institutions that were long stock and wanted to hold the stock when the market moved against them, would buy put options and sell call options to provide a hedge.

The risk reversal would offset the loss on the long stock if the stock continued to fall in price. To help pay for the option that was bought they would sell a call option to collect premium. It was a good method to temporarily get some short delta without upsetting the portfolio of stocks they owned.

They were reversing the risk of their long stock. Therefore, the market makers began to call this strategy a “risk reversal”.

Here’s a risk graph showing AAPL Long Stock…

Figure A. 100 Shares of AAPL Long Stock

To understand how a risk reversal works, it is important to know what a risk graph looks like showing a long stock position.

AAPL is trading at approximately 203.00.

The red line on the risk graph indicates as price goes up, the value of the stock will increase.

The red line on the risk graph also indicates as price goes down, the value of the stock will decrease. There is unlimited risk to the downside.

Here’s a risk graph showing a long stock position with a risk reversal…

Figure B. Long 100 Shares AAPL with a Risk Reversal using short call and long put

Figure B is showing that the price of AAPL is approximately 203. The risk reversal is constructed by buying a 195 put option and selling a 210 call option.

The risk reversal is entered for a net credit of .10 less commissions. As you can see, the long stock is protected and has limited risk to the downside. The upside potential profit has been reduced because a call option has been sold.

The margin to enter this position is $20,293.00.

Pros and cons of using single options to create risk reversals…

When institutions sell options, they have much less margin requirements than you as a retail trader.

An example of a disadvantage of selling a single put is: If you sell a 195 put and the price of the underlying goes below 195, you will start to lose money on the put and keep losing as the underlying price goes down. It could theoretically drop to zero. Therefore, your brokerage will margin your account in a big way.

If you selling a single call option and the underlying price moves above the option strike price, you will start to lose money on that call option. You will also create a good amount of margin by selling a naked call option.

An advantage to you when you sell or buy an individual option is it will usually fill more quickly. This can be helpful if you need a hedge or monies to pay for a hedge right away.

Market Reversals Can Affect Your Long and Short Options…

Have you ever been worried about your position when there was a big move down? You saw your profits diminishing so you bought a put option to protect your positon? Most times I’ll bet you paid a big price to purchase the put on the down day.

When the market moves quickly to the downside, volatility tends to go up. This makes the price to purchase a put rise in cost.

After the market moves down, many times the market will reverse quickly to the upside and the volatility drops. This causes the value of the put you purchased when the volatility was high to go down dramatically. Now your position is not looking so good and possibly losing money. All because you did what you thought was the right thing to do by buying a put.

What a bummer; you protected your trade and you end up losing a lot of the value in the put the very next day. Sometimes the market reverses as soon as you purchase the put, which can be even more frustrating.

If the market reverses quickly and you sold an option to help to pay for the option you bought, it also starts to lose money.

Risk Reversals Using Option Spreads as a Hedge…

As you know, single call and put options can be expensive for you. Single options can cause large margin requirements. As an alternative, you can create a risk reversal using call and put option spreads to reduce your margin and risk.

If you have a long position and would like protection, you could a buy put option spread and sell a call option spread on the same underlying. This can help to hedge your position if the price of the underlying position moves in the wrong direction.

One of the advantages of a risk reversal composed of option spreads is if the market reverses, the option spread will tend to lose less than using single put or call options.

The risk in an option spread is determined by the width of the spread. If your option spread is structured buying one 210 strike call and selling one 215 call option and the price of the underlying moved beyond 210, your risk on the spread would be limited to $500.00 plus commissions. This is calculated by taking the distance between 210 strike call option 215 call option which equals 5 points (5 points times 100 contracts) or $500.00 plus commissions.

Here’s an example of a Risk Reversal using Option Spreads

Figure C. Long 100 Shares AAPL with a Risk Reversal using Spreads

In Figure C 100 shares of long stock is shown by the red line. This risk reversal has been constructed using option spreads. The call spread is short 1 210 call option and long 1 215 call option for a credit of 1.55. The put spread is long 1 195 put option and short 1 190 put option for a net debit of 1.45. This risk reversal is entered for a net credit of .10 (1.55 credit minus 1.45 debit) less commissions.

Look to the left side of the risk graph. The blue line has a small flat area which shows the protection from the long put spread. The option spread offers some protection, but not as much as the single long put which is shown in Figure B.

The margin to enter this position is $20,257.00.

The Directional Option Risk Reversal Position….

Stock or an underlying position is not required to create a risk reversal. A directional risk reversal can be created using just put and call options.

The risk reversal can also be used as a bullish or bearish directional trade. If you are correct in your directional assumption, you will profit.

If you are bearish you can enter a bearish risk reversal position. You would buy a put spread and sell a call spread.

If you are bullish you can enter a bullish risk reversal position. To do this you would sell a put spread and buy a call spread.

The goal with a directional risk reversal is to make a profit then take some of the profits off the table. You can then play with the house money to hopefully gain even more profit.

Here’s a risk graph of a bullish risk reversal using option spreads…

Figure D. AAPL Risk Reversal using only Option Spreads

Figure D is showing a bullish risk reversal with option spreads. The AAPL call spread is long 1 210 call option and short 1 215 call option for a debit of 1.60. The put spread is short 1 195 put and long 190 put for a debit of 1.40. The cost to enter this risk reversal is .20 plus commissions. The margin is the width of the spread which is $500.00

Adjustments can be made to a Risk Reversal…

Risk reversals are very flexible when it comes to adjustments to match your market opinion.

A position can start out as a risk reversal and then be adjusted to accommodate the position as the underlying price movement changes. One adjustment strategy is to take one side of the risk reversal and turn it into a broken wing butterfly.

If the market does not cooperate with your directional bias the position could be adjusted to hedge off some of the upside risk.

What’s a good time to take off your risk reversal?

If your market opinion changes it can be a good time to take off your risk reversal. If you have made an adjustment, you probably have hedged off your risk, so it could be a good idea to take off your risk reversal.

]]>https://aeromir.com/00221/marko-from-optionslam-is-presenting-the-double-eagle-trade/feed0Learn from the Best!https://aeromir.com/0070/learn-from-the-best
https://aeromir.com/0070/learn-from-the-best#respondMon, 30 Apr 2018 20:57:33 +0000https://aeromir.com/?p=70When I was about six years old, I played a game of chess with my dad after dinner.

I always lost.

That started changing when I was around ten years old when I started reading chess books. At some point, I started winning every game and my dad stopped playing chess with me.

I learned that educating yourself with books shortcuts the process of doing it yourself when I was young.

When learning a new skill, reading is a good way to build a solid foundation, but to take it to the next level, you really need a teacher. A mentor.

For example, when I learned to fly, I started out in the class room which gave me a solid foundation of FAA regulations, weather, navigation, etc. But if I actually got in an airplane and tried to fly it, I wouldn't have been able to.

I needed an instructor pilot to show me how to do things. To give me practical advice. How things are really done and even when to to deviate from the normal way of doing things. How to handle emergencies.

In an airplane, the instructor demonstrated something, then the student gets to try it…usually with lots of coaching. This can include hands on the controls or just verbal instruction.

After some practice, with mistakes pointed out and corrected by the instructor, the student starts to get it. At some point, the student can do it with no input from the instructor.

You can fly on your own!

This pattern of using a mentor can be applied to learning any complex skill, including trading.

Having an instructor guide you and help you learn from your mistakes is one of the best ways to become a skillful trader.

Charles Cottle and Ali Pashaei have been teaching options traders for many years. Charles traded on the floor in Chicago and co-founded Thinkorsim.

Charles and Ali are starting a new mentoring program this week.

Charles and Ali will alternate from teaching a weekly class (four per month) and both will answer your questions about trading and give you their opinion about trades you've done or have on now.